[Editorial Analysis] Smart swap

Mains Paper 3: Economy

Prelims level: OMO

Mains level: Discuss the smart swap impacts on Indian economy

Context

• The Reserve Bank of India’s decision to deploy a new instrument from its armoury, a foreign exchange swap auction, throws a much-needed liquidity lifeline to nervous money markets at the fag-end of the financial year.

• The central bank has been regularly infusing cash into the markets through Open Market Operations (OMOs) since the IL and FS default last year.

• The liquidity situation is expected to worsen over the next couple of weeks on advance tax and GST payments, as well as election spending which is known to siphon out currency from the market.

Background

• This pre-emptive move from the RBI may help partly bridge this liquidity deficit and shore up sentiment.

• The swap transaction for $5 billion scheduled on March 26 is materially different from OMOs in the sense that authorised dealers, mainly banks.

• It will be allowed to deposit US dollars with the central bank in exchange for rupees, with an agreement to reverse the transaction at a fixed exchange rate at the end of three years.

• The final exchange rate will be decided by an auction where banks will bid on the forward premium they are willing to pay to participate in this swap.

• If successful, the auction is expected to immediately release $5 billion worth of rupee liquidity into the banking system, thus cooling short-term bond yields.

• There are also three other advantages to the RBI using foreign exchange swaps to bolster market liquidity at this juncture.

• The auction, if successful, will immediately shore up RBI’s foreign exchange reserves by $5 billion.

Implications of the SWAP transaction

• Banks which are currently short on SLR securities and cannot participate in OMOs, will receive liquidity infusions too.

• The swap deal may temporarily bring down hedging costs in the domestic market, helping local firms with foreign exchange exposures hedge their open trade or loan exposures.

• The RBI had last used foreign currency swaps to attract dollar FCNR deposits from NRIs and prop up the rupee during the taper tantrum months of 2013.

• But this swap is unlikely to have a similar effect on the exchange rate, given that the dollars can be domestically sourced.

• In fact, the currency market has already interpreted this move as a signal from the RBI that it is uncomfortable with an appreciating rupee.

Conclusion

• While it is good to see the RBI take cognisance of the liquidity crunch, instead of being in denial mode, and exploring new means to address it.

• It remains to be seen if this move really opens the liquidity tap to distressed market borrowers such as NBFCs.

• The forex swap, like OMOs, essentially puts more money in the hands of banks, who in turn have discretion to decide whether to step up credit to lower-rated borrowers.

• The RBI still needs to come up with a structural solution to address the liquidity issue that is endemic to India’s shallow corporate bond market.

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Prelims Questions:

Q.1) Which of the following statements is/are correct about Gross Domestic Product (GDP)?

1. It is the value of the all final goods and services produced within the boundary of a nation during one year period.

2. In India GDP is calculated by Department of Economic Affairs under Ministry of Finance.

Select the correct answer using the code given below.

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

Answer: A

Mains Questions:

Q.1) RBI’s forex swap may cool short-term bond yields and reduce hedging costs for domestic firms. Explain.

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